Mutual Funds 101: What They are and How They Work

The brain-child of Wall Street, mutual funds are perhaps the easiest and least stressful way to invest in the market. In fact, more new money has been introduced into funds during the past few years than at any time in history. Before you jump into the pool and select a mutual fund in which to invest, you should know exactly what they are and how they work.

What is a mutual fund?

Put simply, a mutual fund is a pool of money provided by individual investors, companies, and other organizations. A fund manager is hired to invest the cash the investors have contributed. The goal of the manager depends upon the type of fund; a fixed-income fund manager, for example, would strive to provide the highest yield at the lowest risk. A long-term growth manager, on the other hand, should attempt to beat the Dow Jones Industrial Average or the S&P 500 in a fiscal year (very few funds actually achieve this; to find out why, read Index Funds - The Dumb Money Almost Always Wins).

Closed vs. Open-Ended Funds, Load vs. No-Load

Mutual funds are divided along four lines: closed-end and open-ended funds; the latter is subdivided into load and no load.

· Closed-End Funds This type of fund has a set number of shares issued to the public through an initial public offering. These shares trade on the open market; this, combined with the fact that a closed-end fund does not redeem or issue new shares like a normal mutual fund, subjects the fund shares to the laws of supply and demand. As a result, shares of closed-end funds normally trade at a discount to net asset value.

· Open-End Funds A majority of mutual funds are open-ended. In simple terms, this means that the fund does not have a set number of shares. Instead, the fund will issue new shares to an investor based upon the current net asset value and redeem the shares when the investor decides to sell. Open-end funds always reflect the net asset value of the fund's underlying investments because shares are created and destroyed as necessary.

Load vs. No Load A load, in mutual fund speak, is a sales commission. If a fund charges a load, the investor will pay the sales commission on top of the net asset value of the fund’s shares. No load funds tend to generate higher returns for investors due to the lower expenses associated with ownership.

What are the benefits of investing through a mutual fund?

Mutual funds are actively managed by a professional money manager who constantly monitors the stocks and bonds in the fund's portfolio. Because this is his or her primary occupation, they can devote considerably more time to selecting investments than an individual investor. This provides the peace of mind that comes with informed investing without the stress of analyzing financial statements or calculating financial ratios.

How do I select a fund that's right for me?

Every fund has a particular investing strategy, style or purpose; some, for instance, invest only in blue chip companies. Others invest in start-up businesses or specific sectors. Finding a mutual fund that fits your investment criteria and style is absolutely vital; if you don't know anything about biotechnology, you have no business investing in a biotech fund. You must know and understand your investment.

After you’ve settled upon a type of fund, turn to Morningstar or Standard and Poors (S&P). Both of these companies issue fund rankings based on past record. You must take these rankings with a grain of salt. Past success is no indication of the future, especially if the fund manager has recently changed.

How do I begin investing in a fund?

If you already have a brokerage account, you can purchase mutual fund shares as you would a share of stock. If you don't, you can visit the fund's web page or call them and request information and an application. Most funds have a minimum initial investment which can vary from $25 - $100,000+ with most in the $1,000 - $5,000 range (the minimum initial investment may be substantially lowered or waived altogether if the investment is for a retirement account such as a 401k, traditional IRA or Roth IRA, and / or the investor agrees to automatic, reoccurring deductions from a checking or savings account to invest in the fund.
The importance of dollar-cost averaging

The dollar-cost averaging strategy is just as applicable to mutual funds as it is to common stock. Establishing such a plan can substantially reduce your long-term market risk and result in a higher net worth over a period of ten years or more.

Understanding Bond Duration

Holders of bonds face a distinct set of risks that may be less obvious to the uninitiated. Thankfully, one of the biggest risks in the bond market - interest rate risk - is easy to determine, using a concept called duration. It's possible to approximate how much a bond's price is likely to rise or fall when interest rates change, a level of certainty that stock investors will appreciate. So before you go out and buy a 30-year Treasury bond in the mistaken belief that it's risk-free, consider its duration.

A Basic Bond

Before diving in, let's take a simple example of a company that wants to borrow $100. It issues a bond that it sells for $100. To attract investors, the issuer of the bond offers to pay $4 a year to holders of the bond, and will do so for 10 years. At that time, the bond matures, and the bold holder gets $100 back. In the parlance of the world of fixed income, we can say that the bond has a face value of $100, a coupon rate of 4% and a maturity of 10 years.

There are many risks to the holder of the bond. The best known may be the risk that the issuer of the bond can't afford to make interest payments or return the principal. But a default, as this scenario is known, isn't the only risk.

Interest Rate Risk
But even a bond with virtually no chance of default - for instance, bonds issued and backed by the US Government - still have risks. Going back to our simple example, let's say that the day after the bond is issued, interest rates rise to 5%. The owner of that bond might kick herself. If she had waited a day, she could have bought a bond that paid 5% a year. That makes her bond less valuable, and this will be reflected if she tries to sell the bond to someone else. She may not be able to get back her $100.

The seesaw relationship between interest rates and bond prices is a fundamental concept of bonds. But some bonds have greater sensitivity to changes in interest rates. Bond investors don't have to guess at this exposure. A bond's modified duration, a figure derived from several factors, measures this risk and tells the investor how its price is likely to change when market interest rates go up or down. A bond with a duration of six years would be expected to fall 6% in price for every 1% increase in market interest rates.

Elements of Duration
The concept of duration is straightforward: It measures how quickly a bond will repay its true cost. The longer it takes, the greater exposure the bond has to changes in the interest rate environment.

Here are some of factors that affect a bond's duration:

· Time to maturity: Consider two bonds that each cost $1,000 and yield 5%. A bond that matures in one year would more quickly repay its true cost than a bond that matures in 10 years. As a result, the shorter-maturity bond would have a lower duration and less price risk. The longer the maturity, the higher the duration.

· Coupon rate: A bond's payment is a key factor in calculating duration. If two otherwise identical bonds pay different coupons, the bond with the higher coupon will pay back its original cost quicker than the lower-yielding bond. The higher the coupon, the lower the duration.
Using Duration to Your Advantage

Knowing the duration of a bond, or a portfolio of bonds, gives an investor an advantage in two important ways:

· Speculating on interest rates: Investors who anticipate a decline in market interest rates - as a result of, for instance, a simulative rate cut by the Federal Reserve - would try to increase the average duration of their bond portfolio. Likewise, investors who expect the Fed to raise interest rates would want to lower their average duration.

· Matching risk to your tastes: When selecting from bonds of different maturities and yields, or comparing bond mutual funds, duration allows you to quickly determine which bonds are more sensitive to changes in market interest rates, and to what degree.

Calculating Duration

Start by determining the value of a bond's yearly cash flow, adjusted to give greater value to payments that are made sooner rather than later. Divide that figure by its price to calculate its duration. Online calculators make this easy.

Bonds 101

What Are They?

Say you are in the grocery store with a friend on a Thursday afternoon and see something you need for your house; a broom for example. Although you get your paycheck the next day, you ask your shopping buddy to borrow a few dollars so you can purchase the broom now, in return for which you will not only pay them back tomorrow, but buy them dinner as well. Your friend, finding these terms acceptable, loans you the money and you purchase the item.

This is, in essence, what happens in the corporate world when a company issues bonds. Generally, as a business grows, it doesn't generate enough cash internally to pay for the supplies and equipment necessary to keep it growing. Because of this, most businesses have one of two options. They can either 1.) sell a portion of the company to the general public by issuing additional shares of stock, or they can 2.) issue bonds. When a company issues bonds, it is borrowing money from investors in exchange for which it agrees to pay them interest at set intervals for a predetermined amount of time. In essence, it is the same thing as a mortgage only you, the investor, are the bank.

Why Would Anyone Invest in Bonds?

Most everyone knows that over the long-run, nothing beats the stock market. This being the case, why would anyone invest in bonds? Although they pale in comparison to equities in the long run, bonds have several traits that stocks simply can't match.

First, capital preservation. Unless a company goes bankrupt, a bondholder can be almost completely certain that they will receive the amount they originally invested. Stocks, which are subordinate to bonds, bear the brunt of unfavorable developments.

Secondly, bonds pay interest at set intervals of time, which can provide valuable income for retired couples, individuals, or those who need the cash flow. For instance, if someone owned $100,000 worth of bonds that paid 8% interest annually (that would be $8,000 yearly), a fraction of that interest would be sent to the bondholder either monthly or quarterly, giving them money to live on or invest elsewhere.

Bonds can also have large tax advantage for some people. When a government or municipality issues various types of bonds to raise money to build bridges, roads, etc., the interest that is earned is tax exempt. This can be especially advantageous for those whom are retired or want to minimize their total tax liability.